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June 3, 2014

Are Bonds Really That Safe?

Factors outside an advisor’s control have made bonds riskier than clients are accustomed to

Fed decisions have more than cut bond income in half.

Income markets are “inverted,” and the historically safe bond market is better used as a risk management tool than an actual source of income, according to Charlie Farrell, CEO of Denver-based Northstar Investment Advisors.

“Historically, and I’ve felt this way as well, bond yields and bond income was a safe way to access a healthy amount of retirement income once you needed to start taking distributions,” he told ThinkAdvisor on Thursday. “Today, things really are inverted in the income markets. If you look at what we went through in the financial crisis, people know that stock dividends were cut — let’s look at the S&P 500 in general — and they were: A lot of financial firms cut dividends, some even eliminated them.”

However, Farrell continued, dividend income declined by about 21% since its peak in 2007 prior to the crisis. Now, not only have they recovered, they’re 23% to 24% higher than they were at the peak, while bond yields are around 50% of what they once were, Farrell said.

Farrell used 10-year Treasuries as an example. Say you have $1 million in securities that generates about $45,000 or $50,000 per year. “Now that million dollars of securities — you still have your money, but it might only be generating $25,000 or $28,000 a year. You’ve had a significant cut in your bond income, even though there were no defaults and you didn’t make any bad investment decisions.”

This is certainly a long-term situation, too, Farrell said. “Going forward it’s even more difficult because now we’re looking at bond yields, let’s say 2.5% to 2.75%. You’ve got stock dividends for a lot of high-quality companies that are equal to or higher than that right now, and dividends are tending to grow anywhere between 5% to 7% a year. If you look out over the next 10 to 15 years, which one of these income streams is likely to be riskier?”

The big risk with bonds, according to Farrell, is that “decisions made by the Fed that are totally out of our control have more than cut the income on the bond side in half. Yeah, we think of that as safe, but there’s really nothing you can do about it.”

Furthermore, he said, the drop in income from dividends was less than the drop from falling interest rates.

“Short-term interest rates went from 3% to zero,” he said. “You have money sitting in a short-term fund, you might have been getting $30,000 per million — now you’re getting zero. Bond income is not really in terms of safety if you think, ‘Yes, it’s guaranteed,’ but that’s not the only safety you need to think about.”

Still, Farrell acknowledged that while equities don’t come with the risk that the Federal Reserve will keep interest rates low, they have their own risks. Clients have to be willing to accept that dividends aren’t guaranteed, however, “if you diversify that and focus on high-quality companies you may actually find that the income production on the stock side is more reliable than the income production on the bond side.”

That doesn’t mean advisors looking for retirement income for their clients should eschew bonds altogether. “Obviously dividends aren’t guaranteed so you’ve got to have a plan B,” Farrell said. “You want bonds because you’ve got some principal protection.”

He said that high-quality bonds generally hold up well in a crisis, in addition to being simple and straightforward. Unfortunately, if you’re only generating 2.5% to 2.75% and taking out 4% or 5% a year, “you’re automatically reducing your amount of income going forward because you’re going to sell principal to meet your 4% or 5% distribution, which means you’ll have fewer bonds next year. It’s just a downward spiral.”

Farrell said that as clients enter retirement and begin taking distributions, they’re “moving to a phase where you probably can’t rely heavily on the fixed income market to make your retirement income work. You have to rely more on it as a risk management feature to bridge the crisis gaps, and you have to look at other sources of income.”

Farrell said that in general, advisors should keep enough fixed income in their clients’ portfolios to bridge a gap of “a minimum of five and probably out to an eight-year cycle of really bad market returns. […] You’d want a minimum of probably 30% in fixed [income] in order to bridge a gap that’s pretty significant and not get too scared as you eat through that and as the bad market extends you don’t panic and begin selling equities at the wrong time.”

So how do you overcome resistance from clients who are used to thinking of stocks as too dangerous for their retirement years?

“A lot of advisors, us included, have been telling clients that for years,” Farrell said. “It’s the old saying of ‘When the facts change, I change my opinion.’ That’s the reality; the facts of the bond market have changed substantially over the last six or seven years. You have to take a look at the full scope of your retirement cycle.”

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